Q&A with the Portfolio Manager: Greater China Equities

1 Since 2023, Greater China equities have benefitted from the reopening pivot, a stabilization in Mainland China’s property sector, and pro-growth government policies. Can you share the latest sector outlook and illustrate how you intend to capture this rally? 

As we had highlighted earlier this year, the service sector’s recovery should be the most significant development to emerge from Mainland China’s reopening. As it evolves, consumption-related plays are fueled by the recovery and reopening dynamics across sectors.¹ Before the government’s official announcement in Q4 2022, as active managers, we were already positioned in a variety of subsectors that were able to benefit from the reopening, including online platform companies, the hospitality sector (online travel agencies and hotels), and select healthcare firms (medical devices and equipment). These investments delivered positive returns in the Q1 2023 rally. We also selectively took profits in some consumer names, which included luxury retailers, Macau gaming, and duty-free companies.

We continue to believe that various consumption-related sectors (e.g., e-commerce, hospitality, and domestic sportswear brands) may ride on a potentially sustainable recovery into the second half of this year on the back of higher demand, better pricing, and volume growth.

We had also expected that a strong rebound in consumption would trigger investment appetite. In fact, the reopening accelerated the pace of digitalization of traditional industries, and our positions in innovation-related themes, such as application software, semiconductors, and online gaming, are well supported in this rally.

2 Due to geopolitical tensions, COVID-19 disruptions, and rising labor costs, the past few years have seen multinational firms shift part of their global supply chains out of Mainland China and pursue an additional supply chain in other places such as Southeast Asia and Mexico (also known as the China-plus-one strategy). What’s your view of this diversified supply chain model? Which strategic industries does Mainland China retain in the global supply chain?

Global manufacturing GDP totaled around US$14.2 trillion in 2021 and was underpinned by thousands of companies in traditional industries.² Nowadays, goods aren’t merely from traditional industries; they could include electric vehicles (EVs), semiconductor products, and innovative software/hardware products that call for a new and diversified supply chain.

Mainland China’s manufacturing—too big to decouple

The value of Mainland China’s manufacturing activity was approximately US$4.9 trillion in 2021, making it the largest manufacturing economy (over 30%) globally in 2021, ahead of the United States and Europe (about 16% each). Despite Mainland China’s sheer size and dominance, the country’s manufacturing GDP (in local currency terms) continued to show growth momentum, which rose by 9.8% year over year (YoY) in 2020/2021 and 7.0% YoY in 2021/2022.³

In addition, Mainland China is now emerging as the single largest market for industrial original equipment manufacturers (OEMs)³—companies within the sector grow their presence in the country not only because of its manufacturing capabilities, but also due to market proximity and onshore customer needs. We believe the linkages between Mainland China’s manufacturing supply chain and the rest of the world remain strong.

From Made in China to Made by China

We acknowledge that over the past few years, we’ve shifted to a scenario where more supply chains were moving out of—or were trying to find a replacement for—the country due to geopolitical tensions, COVID-19 disruptions, and rising labor costs. Indeed, multinational companies have been rethinking the two-decade-old production model (“Made in China”) and have begun to advocate for the China-plus-one model to avoid overconcentration in the country’s production lines in order to diversify business lines and reduce risk.

Outside of these firms, we also find Chinese exporters becoming more internationalized and have taken the same path as Japanese and South Korean companies. They’re building plants and shifting production bases offshore⁴ to hedge against rising local labor and environmental costs as well as growing geopolitical risks so clients can place their orders in a third country. For example, it’s reported that furniture companies are moving to Mexico (in addition to large home appliance and car manufacturers) in order to serve customers in the United States and take advantage of a 2020 North American trade deal.⁵ Ultimately, these Chinese exporters’ goods (Made by China) will be labeled as Made in Mexico.

The consumer electronics sector provides another example: An international smartphone maker expanded its production lines to India through its Chinese contract manufacturers under India’s Production Linked Incentive Scheme. These smartphones are made by Chinese manufacturers in India and will be labeled as Made in India.

Mainland China expands into high-end sophisticated supply chains

As highlighted in our 2023 outlook, Mainland China has focused on supply chains that drive technology innovation/localization and manufacturing upgrades. In fact, the country had not lost any ground in global manufacturing as of 2021. The economy may lose market share in the supply chains of low-tech industries such as textiles and footwear to Vietnam and Thailand while gaining a larger share of more sophisticated sectors such as EV and batteries exports.

Source: World Bank Data, Morgan Stanley Research, as of May 1, 2023. Percentage figure represents Mainland China and the United States’ contribution to global manufacturing GDP.

Furthermore, the country is adapting to supply chain changes by moving up the quality scale in EV production. Mainland China is also self-reliant in the EV battery supply chain, and it’s been estimated that China-made EV battery volume is more than double that of every other country combined.⁶ Mainland China’s complete EV supply chain spans mining rare raw materials (e.g., cobalt, nickel), processing and refining (with government support in the form of cheaper land and labor), component manufacturing, and battery assembly. Most global companies would need to partner with Chinese component manufacturers to enter or expand in the EV industry.

As mentioned earlier, businesses such as international OEMs, are unlikely to move their entire supply chains out of Mainland China since the country is often their single largest market. Instead, these companies need to maintain access and strike a balance between customer proximity and manufacturing location. The manufacturing universe is also highly interconnected, and logistics must be managed to control costs. For example, around 45%⁷ of car parts and components used by auto firms in the United States and Europe have, at some stage, moved in and out of Mainland China.

We also believe that technology-savvy domestic auto suppliers will likely gain market share on the back of localization efforts in Mainland China. Instead of sourcing their components elsewhere, international OEMs may need to increase their reliance on China-based suppliers.

3 U.S.-China relations have been under pressure since 2018, and the tech race has been raised as a market concern. How could this affect Mainland China’s medium- to longer-term structural growth story?

In addition to boosting middle-class consumption and becoming more self-reliant, we think Mainland China must focus on business-model innovation, technology localization, and advanced manufacturing. Our team has identified opportunities in the automation and artificial intelligence (AI) space:

• Automation is a fast-growing area that rides on the trend of labor replacement owing to rising wages and labor shortages as a result of aging populations and the rapid expansion of emerging end markets such as consumer electronics, automobiles, batteries, and solar/semiconductors.
  

Source: Ministry of Industry and Information Technology, August 2022.

Amid the push for greater technological self-sufficiency, Mainland China has set a goal of doubling its industrial robot density from 2020 to 2025. We expect domestic leaders in industrial robots to benefit from the trend as they possess the industry know-how in local markets and understand import-substitution demand from customers in the country.

In a broader sense, automation can be subcategorized into factory and process automation. Within Mainland China, 41% of the automation market relates to factory automation⁸  (also known as discrete automation), whereas process automation accounts for the remaining 59% of the market.

Source: MIR Databank, HSBC Qianhai Securities, August 2022.

In terms of sales breakdown (by industry), machine tools represented 25% of the factory automation market in 2021, followed by semiconductor and solar (12%), textiles (6%), elevators (5%), and lithium batteries (5%).

We believe that industrial robotic manufacturers with leading market positioning, vertical integration capabilities, and margin improvement potential for localized components could outperform. We expect improving new order flows as industrial capex picks up.

• AI: According to International Data Corporation, global revenue for the AI market including software, hardware, and service sales is expected to increase at a compounded annual growth rate (2022 to 2026) of 19% to reach US$900 billion by 2026. AI investment in Mainland China is expected to reach US$26.69 billion by 2026,⁹ accounting for 8.9% of global investment.

Large language models (LLMs), which are also known as foundation models, use deep learning in natural language processing. An LLM is a transformer-based neural network that predicts the text that is likely to come next. The development of LLMs is significant as it can adapt to a wide range of tasks.

On the regulatory front, the Cyberspace Administration of China drafted measures to manage generative AI services and encourage the use of safe and reliable software, tools, and data resources.¹⁰ This echoes Chinese President Xi Jinping’s call to develop AI technology amid the race with the United States and reflects the government’s objective of building its own governance universe.

Within the AI supply chain, we believe that Mainland Chinese hardware and software companies, as well as Taiwanese hardware firms exposed to AI infrastructure, components, and applications, could benefit.

In terms of hardware requirements, semiconductors and networking infrastructure can expect to experience a boom from AI training and interface perspectives. Major components required for a machine learning model include logic processors (i.e., to perform parallel computations), memory (in particular, dynamic random access memory with high bandwidth), and networking equipment (e.g., switches and routers to link servers to cloud/edge devices). In terms of software, Mainland China’s internet giants and start-ups have begun to develop homegrown OpenAI capabilities, for instance, the integration of AI into web browsers, customer messaging tools, education software, industrial software for the retail and finance industries, and online gaming.

We believe that software leaders with significant customer bases could benefit from subscription-based revenues derived from future AI applications. Content creators and advertising platforms have already started to use AI to improve efficiency and lower development costs.

Source: Center for Research on Foundation Models (CRFN), Stanford University Institute for Human-Cantered Artificial Intelligence, 2021. Large language models (LLMs) can centralize information from several data modalities to adapt to a wide range of tasks from answering questions to extracting information and identifying images. For illustrative purposes only.

Conclusion

Mainland China is adapting to supply chain changes and moving up the manufacturing quality scale. With rising demand for advanced manufacturing, we believe domestic automation suppliers will likely gain market share.

The technology localization trend remains intact. We believe AI/software, semiconductor equipment, and hardware technology companies with strong research and development capability should thrive and gain market share. Selective gaming companies should also see better topline growth on the back of gaming approvals.

1 National Bureau of Statistics in China, Bloomberg, as of April 18, 2023: domestic demand for goods and services rebounded and drove retail sales higher; Ministry of Culture and Tourism, as of April 6, 2023: domestic tourism (leisure and business) has rebounded to over 80% of 2019 levels. 2 Morgan Stanley. Traditional industries include automotive, aerospace, energy,  and food and beverage through to consumer appliances, furniture, and textiles. 3 Morgan Stanley Research, as of May 1, 2023. 4 China’s Ministry of Commerce. As of the end of 2020, the foreign direct investment from China in Mexico totally amounted to approximately US$1.17 billion U.S. dollars. 5 U.S–Mexico–Canada Agreement, May 15, 2023. 6 Estimates from Benchmark Minerals, a consulting group. 7 Morgan Stanley Research. 8 HSBC Qianhai Securities, data as of 2021. Process automation refers to products such as chemicals, power, steel, and refineries, which typically need more software than factory automation given the data analysis required. Both factory automation and process automation will require control systems. In addition, process automation is typically project based whereas factory automation is usually OEM based. 9 IDC CHINA–2023 China AI Market Spending Forecast, March 29, 2023. 10 Reuters, April 11, 2023.